Activity 2 : Tutorials on Risk and Return

1. An analyst estimates that a stock has the following probabilities of return depending on
the state of the economy. What is the expected return of the stock ?
State of Economy Probability Return
Good .1 15%
Average .6 13
Bad .3 7
( Ans : E( r ) 11.4%)

2. The following information is available in respect of the return from security HDFC under
different economic conditions:
Economic Condition Return Probability
Good 20% .1
Average 16% .4
Bad 10% .3
Poor 3% .2
Find out the expected return and standard deviation of the HDFC stock.
(Ans: E(r) 12%, ϭ-5.6%).
ER = 12%, Risk = 5.5%

3. Calculate the Expected Return and Risk of both the stocks.

State of Economy Probability of Rate of Return

occurrence ABB Ltd ACC Ltd
Boom 0.30 16 40
Normal 0.50 11 10
Recession 0.20 6 -20
Which stock should a risk averse Investor choose to invest in?
Return Risk
ABB 11.5 12.25
ACC 13 441

ABB should be chosen

4. The return on securities SBIN and PNB are given below

Probability SBIN PNB
0.2 -20% -15%
0.5 18% 20%
0.3 50% 10%
 In your opinion what are the risk and expected return for stock SBIN and PNB?
Assume that of Rs.10000 value of portfolio, 9000 is invested in SBIN and 1000 in PNB.
What is the expected return of the portfolio ?
(Ans : E ( R ) = 20, 10 ; ϭ = 24.33%, 13.33% ; 19% )

5. A share is available today at a price of Rs. 102. After one year, the company is expected
to declare a dividend of Rs. 14 per share. You expect to sell the share for Rs. 105 (ex-
dividend). Find out the holding period return from your investment. (Ans: 16.67%)

6. Blackstone Assets Management Ltd. is evaluating the rate of return on two of its assets,
I and II. The asset I was purchased a year ago for Rs. 4, 00,000 and since then it has
generated cash inflows of Rs. 16000. Presently, it can be sold for a price of Rs. 4, 30,000.
Asset II was purchased a few years ago and its market price in the beginning and at the
end of the current year was Rs. 2, 40,000 and Rs. 2, 36,000 respectively. The asset II has
generated cash inflows of Rs. 34,000 during the year. Find out the rate of return on
these assets.
R (I) = 10.69 % R(II) = 12.71 %

7. In a portfolio of the company, Rs. 2,00,000 have been invested in asset X which has an
expected return of 8.5%, Rs. 2,80,000 in asset Y, which has an expected return of 10.2%
and Rs. 3,20,000 in asset Z which has an expected return of 12%. What is expected
return for the portfolio?(Ans: 10.495%).

8. Consider a risky portfolio. The year end cash flow derived from the portfolio will be
either Rs.50,000 or Rs.1,50,000 with equal probabilities of 0.5. The alternative riskless
investment in T-bills pay 5%.
1. If you require a risk premium of 10% how much will you be willing to pay for the
portfolio?
2. Suppose the portfolio can be purchased for the amount you found out in step 1
what will be the expected return of the portfolio?
3. Assuming the risk premium is 15 % , what will be the price an investor will be willing
to pay?
4. Compare answers from 1 and 3, conclude the relationship between required risk
premium on a portfolio and the price at which the portfolio will sell?

a. The expected cash flow is: (0.5  $50,000) + (0.5  $150,000) = $100,000
With a risk premium of 10%, the required rate of return is 15%. Therefore, if the value of the
portfolio is X, then, in order to earn a 15% expected return:
Solving X (1 + 0.15) = $100,000, we get X = $86,957

b. If the portfolio is purchased at $86,957, and the expected payoff is $100,000, then the expected rate
of return, E(r), is:
 $ 100,000−$86 ,957
$ 86,957 = 0.15 = 15%
The portfolio price is set to equate the expected return with the required rate of return.

c. If the risk premium over T-bills is now 15%, then the required return is:
5% + 15% = 20%
The value of the portfolio (X) must satisfy:X (1 + 0.20) = $100, 000  X = $83,333
d. For a given expected cash flow, portfolios that command greater risk premiums must sell at lower
prices. The extra discount in the purchase price from the expected value is to compensate the investor
for bearing additional risk.

9. Two stocks Box Ltd and Cox Ltd are both selling for Rs.100 per share each. The rupee
return(dividend plus price) of these stocks for the next year is assessed as follows

Economic Condition
High Growth Low Growth Stagnation Recession
Probability 0.3 0.4 0.2 0.1
Return on Box Ltd 100 110 120 140
Return on Cox Ltd 150 130 90 60
Calculate the expected return and risk of investing (i) Rs.1000 in equity stock of Box Ltd
(ii) Rs.1000 in equity stock of Cox Ltd (iii) Rs.500 each in equity stock of Box and Cox Ltd
(iv)Which of the 3 options will you choose and why?

(i) Er = Rs.1120, SD = Rs.116.6

(ii) Er = Rs.1210 , SD = 291.4
(iii) Er = Rs.1165, Sd = Rs.89.6

10.The stock of ACE and ENT are currently selling for Rs.50 per share each. The returns
of these stocks for the next year would be as follows.
states of High growth Low growth stagnation Recession
economic
conditions
Probability 0.3 0.3 0.2 0.2
Return on ACE 55 50 60 70
Return on ENT 75 65 50 40
Calculate the expected return and standard deviation of
(i)Rs 1000 invested in equity stock of ACE
(ii) Rs 1000 invested in equity stock of ENT
(iii) Rs 500 invested in equity stock of ACE and Rs.500 in ENT
(iv) Rs.700 invested in equity stock of ACE and Rs.300 in the equity stock of ENT.
Which of the above four options would you choose and why?
(i)Rs.1150,Rs.143.18
(ii)Rs,1200,Rs.264.58
(iii)Rs.1175,Rs.84.41
(iv)Rs.1165, Rs.57.66